United States: Mixing Oil And Water: Backdated Stock Options Under Code § 409A

Two recent IRS Notices—Notice 2006-79 and Notice 2006-100—provide important relief and clarification respecting the taxation of nonqualified deferred arrangements. These notices are the latest guidance implementing Internal Revenue Code § 409, which was added to the Code as a part of the American Jobs Creation Act of 2004 (the "Act"). In the Act’s legislative history, Congress signaled its desire to exempt stock options granted at fair market value from Code § 409A, and the regulators have largely respected Congress’s wishes in this regard. Discounted options are another matter. Congress clearly viewed the discount as a deferral of compensation subject to the new regime.

Recent press reports of SEC investigations have focused the attention of the regulators and the public on "backdated" stock options. Option "backdating" is the term that has generally been applied in the media to instances where executives have intentionally dated an option at a date earlier than the actual date of grant for the purpose of reporting a lower strike price, thereby increasing the spread (or gain) at exercise. While there are certain instances where this was done intentionally, there are also cases where the lapse resulted from an inadvertent failure to follow the company’s option grant practices. For SEC reporting and other purposes, the proximate cause of the backdating is irrelevant. A public company that discovers option backdating (either as a result of its own investigation or as a result of an SEC or other investigation) can expect to report a financial expense for a prior accounting period.

As we noted in our October 10, 2006 Client Alert, Notice 2006-79 generally extended the transition period during which arrangements covered by Code § 409A can be amended to conform to Code § 409, but denies the benefit of the extension to backdated stock options for public companies that did not timely report the financial expenses. Notice 2006-100 provides interim rules governing reporting and wage withholding under Code § 409. This client advisory focuses on the particular provisions of Notices 2006-79 and 2006-100 that together affect discounted stock options with a particular emphasis on backdated options.

In Notice 2005-1 and a proposed regulation issued in the fall of 2005, the regulators provided a transitional period during which discounted options could be either reformed to meet the requirements of, or satisfy an exemption from, Code § 409A. The alternatives are as follows:

• Adjustment. The exercise price of the option can be reset to the fair market value of the stock as of the original legal date of grant. The option issuer could compensate the holder for the lost discount either in cash or with restricted property, so long as the cash payment or vesting of the restricted property was deferred into a later year.

• Replacement. The discounted option can be replaced with restricted stock or restricted stock units, or with a new option, or with a stock appreciation right granted at current fair market value.

• Cash-Out. The option can be surrendered for a cash payment on a fixed date in a later year.

• Reformation. The option can be reformed to conform to the requirements of Code § 409A. At a minimum, this requires a fixed payment date.

Notice 2006-79 extended the transition relief to the end of 2007, with one exception. The extension does not apply to any stock option or stock appreciation right (stock right) that (quoting from the notice):

(A) was granted with respect to stock of a corporation that as of the date of grant had issued any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934;

(B) was granted to a person who, as of the date of grant, was subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934 with respect to such issuer; and

(C) with respect to the grant of such stock right, such corporation either has reported or reasonably expects to report a financial expense due to the issuance of a stock right with an exercise price lower than the fair market value of the underlying stock at the date of grant that was not timely reported on financial statements or reports for the period in which the related expense should have been reported under generally accepted accounting principles.

In other words, backdated options are ineligible for the further extension of the transition period. Therefore, correction must take place in 2006 in order to avoid the imposition of tax under Code § 409A. Correction involving a named executive officer (i.e., an executive "subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934") could require the filing of SEC Form 8-K as well as proxy statement disclosure, which could raise a red flag to shareholders and regulators alike.

Complicating matters, the proposed Code § 409A regulation contains a plan aggregation rule under which the deferred compensation arrangements in which an employee participates are broken down by specific categories. The categories are:

• defined contribution plans;

• defined benefit plans;

• severance (or "separation pay") arrangements; and

• stock rights (including phantom stock and discount stock appreciation rights).

The Code § 409A plan aggregation rule provides that each arrangement in which an employee participates in each of the foregoing categories are "aggregated," or treated as a single plan under Code § 409A. Thus, all stock-based rights covered by Code § 409A in which an employee has an interest are treated as one deferred compensation plan with respect to that employee. The importance of this is that a violation of Code § 409A with respect to one option will trigger adverse tax consequences (income tax, a 20% excise tax and potential interest penalties) under all the employee’s options covered by Code § 409A, whether or not exercised. A violation of Code § 409A with respect to a discount option occurs automatically when an option holder exercises the option before it has been amended to comply with Code § 409A. Standard option language permitting the optionee to exercise the option at his or her discretion does not comply with Code § 409A.

NOTE: Representatives of the IRS and Treasury have informally expressed the view that, even if an option holder has exercised a noncompliant option covered by Code § 409A, substituting discounted options covered by Code § 409A for fair market value options will allow the option holder to escape the plan aggregation rule with respect to his or her stock rights, but amending the remaining options to comply with Code § 409A will not.

As we previously noted, Section 16 reporting persons have until the end of this year to either make Code § 409A covered options exempt from Code § 409A by resetting the exercise price to fair market value on the date of grant or by amending the option to comply with Code § 409A. If a Section 16 person fails to meet this deadline, his or her options will be subject to income taxation, the 20% excise tax and interest penalties under 409A as if the option were exercised on December 31st of the applicable year.

2005
If an option was vested as of December 31, 2005, the Section 16 person will be subject to taxation (plus the 20% excise tax and potential interest penalties) based on the fair market value of the stock as of December 31, 2005 minus the exercise price and what, if any, the person may have paid for the option.

2006
If an option was vested as of December 31, 2005, the Section 16 person will be subject to taxation (plus the 20% excise tax and potential interest penalties) based on the fair market value of the stock as of December 31, 2006 minus the exercise price and what, if anything, the person may have paid for the option, and prior amounts included in taxation from 2005.

If a person exercised a discounted option in 2005, which does not comply with Code § 409A as of the date of exercise, he or she is subject to taxation (including the 20% excise tax and interest penalties) based on the option spread at the time of exercise less any prior amounts included in income. The payer must issue an original or corrected Form 941 and Form W-2 or 1099-MISC, as the case may be, by the 2006 filing deadline, but wage withholding is not required. To the extent that amounts were not previously included in income in 2005, the option holder must file an amended return. If the option holder timely complies with these requirements, no further tax penalties will be imposed. Similar reporting rules apply in 2006, but wage withholding is also required. For this purpose, Notice 2006-100 provides two alternatives. The employer can either withhold the necessary amounts from the option holder’s other income or advance the withholding amounts (and treat them as additional income, with respect to which further withholding is not required).

Persons, other than Section 16 persons, have until the end of 2007 to take remedial action with respect to discounted options. Nonetheless, all discount option holders should realize that option exercises prior to correction in accordance with Code § 409A will impact their other options and stock rights subject to Code § 409A, and that failure to correct any Code § 409A issues may have adverse tax consequences retroactive to 2005.

The consequences of stock option backdating affect both incentive stock options (ISOs) and nonqualified stock options. Because ISOs must be issued at fair market value as of the date of grant, a backdated ISO is unlikely to qualify for ISO treatment. Nonqualified options, though nominally granted at fair market value, may nevertheless be discounted as a consequence of backdating. In either case, the result is an option that is discounted for Code § 409A purposes. Therefore, correction under one of the options described above is necessary in order to avoid current tax and penalties.

The application of Code § 409A to backdated options will require immediate action (i.e., before year end), which in some cases will be either infeasible or impossible. Where this is the case, the employer or contactor will need to follow the tax treatment prescribed by Notice 2006-100. While onerous, additional penalties and interest can be avoided by acting expeditiously. Where correction is possible, the better approach is to reprice the backdated option to fair market value so as to avoid the application of Code § 409A altogether, thereby sidestepping the plan aggregation rules. Lastly, if the only available correction method is to conform the backdated option to Code § 409A, then the employer or contractor must either comply with the plan aggregation rule or be prepared to defend an interpretation of the rules at odds with the views of the government.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.